US Regulators Air Concerns Over Smart Contracts

Two members of prominent US regulatory bodies took to the stage earlier this week to talk about the difficulties
of overseeing the exploding industry
of smart contracts.

The representatives of the federally controlled Commodity Futures Trading Commission (CFTC) and the self-enforcing Financial Industry Regulatory Authority (FINRA) took turns explaining why they were watching the industry so closely.

Speaking during a panel at the Smart Contracts Symposium hosted by the Chamber of Digital Commerce, the regulators agreed that while action should be taken, it shouldn’t be rushed.

Addressing a group of about 250 people at Microsoft’s New York headquarters, CFTC chief economist Sayee Srinivasan said that, while exploration of the blockchain space had been relatively slow for the past years, the rising cost of capital
has begun to make investment worth while and the pace is accelerating.

Srinivasan acknowledged that while regulators will “always lag the market practices” of the rapidly growing financial technology industry, smart contracts themselves could eventually help with the work.

If implemented on a national scale a so-called “regulatory node” on a distributed ledger could give Srinivasan and his colleagues unprecedented auditing powers.

Srinivasan took issue with those in the industry who argued that agreements built using self-executing will someday render regulators redundant.

“If there’s money to be made, there’s people being incentivized to game the rules,” said Srinivasan, who extended an open invitation to firms interested in discussing how a regulatory node might function. “There will be a role for the regulators, though there’s this belief that code is law.”

In what ended up being a dominant theme of the discussion, Srinivasan described the fight against financial fraud as primarily an “operational issue” about what to do when things go wrong. Namely, he listed the ability to rollback and reverse fraudulent transactions.

Earlier this year, CFTC commissioner Christopher Giancarlo said
blockchain could be “the biggest technological innovation in the financial services industry and financial market regulation in a generation or more”.

But, in the lead up to the regulatory transition of power to President-elect Donald Trump, the agency’s pace has been called into question. Last month, the Agriculture Committee of the US House of Representatives sent a letter
to the CFTC asking it for clarity on its digital currency stance.

While Srinivasan has extended an open invitation to those interested in further exploring a blockchain-based regulatory node, Jain says her agency – which writes and enforces rules governing the activities of almost 3,900 securities firms – has been studying smart contract regulation from its own clients.

Speaking on her own behalf and not the regulator’s, Jain said:

“At FINRA, we have receive a handful of applications that have given us the opportunity to engage with clients.”

Based on her research so far, Jain said she and other regulators are worried about “regulated entities operating in a trustless environment.”

Not just because those entities might break laws in new ways, but because of concerns over the source of data being used and what happens if the data is corrupted.

She said:

“The alarm bells ring off in my head.”

The DAO’s dangerous precedent

Also on the panel were two members of the industry who might someday be subject to the decisions these regulators make.

Each of these entities expressed concerns over the precedent set forth by The DAO
, the first large scale implementation of smart contracts, that collapsed when the self-executing code running on the ethereum blockchain was tricked into sending its funds to an attacker’s account.

Executive director of digitization for the CME Group Sandra Ro said that, as a regulated entity, her company was “very aware” of its need to be compliant in an environment that crosses 150 different countries.

Ro recounted multiple instances when problems with the financial infrastructure had to be correct, and wondered out loud what would have happened if the network had been run via self-executing smart contract.

“How do we code when situations go berserk?” she asked.

Then, partner Dax Hansen of the Perkins Coie law firm that specializes in blockchain said that the key differentiator between The DAO and future smart contract implementations needs to be the ability to undo an action.

Smart contracts left to run uninterpreted by regulators would leave mainstream finance open for attack.